An Examination Of The Consistency Of Risk Differentials Between Historical Measures Of Risk And The Risk Implied By Economic Value Added

Abstract

The corporate world is continually striving to identify an effective means of evaluating management performance. Corporate concern over this issue stems from both the perspective of managerial compensation and maximizing shareholder value. Some companies have used such measures as returns on assets, equity, or investment. Some have relied on other measures like inventory management, trade credit management, or cash management. The common ground shared by these measures is that they rely on accounting measures of firm activity. The weakness of using such means to measure firm performance is that they are driven by a rule-based system, and anyone with sufficient understanding of the rules can manipulate the information to present the picture of the firm’s performance in a way that may not track with the reality of the firm’s performance. This does not suggest that managers will engage in such numerical fiddle-dee-dee; rather, it suggests that the opportunity to do so exists, and must somehow be incorporated into the shareholder’s interpretation of the reported performance. This situation leaves firms in the position of needing a better performance measure by which to evaluate the work of its management. One alternative performance measure offered to meet this need was introduced in the early 1980's by Stern Stewart and Company and is known as Economic Value Added or EVA®.(Ehrbar, 1998) The basic premise underlying EVA is an effort to encourage managers and other employees to think and act as entrepreneurs rather than employees.